I presented an overview of five types of unallowed income tax losses that must be carried forward to the following year in my MarketWatch RetireMentors article, 5 Carryovers to Remember When Doing 2016 Tax Planning that was published on May 4. This post will discuss one of them, passive losses, in more detail since the rules for calculating and using them are complicated and it affects a lot of people.
Prior to the Tax Reform Act of 1986, rental property losses could be deducted in their entirety. Congress imposed two significant changes for rental property owners with tax losses when it enacted the passive loss limitation rules:
- After the net loss on each property has been calculated, the allowable portion of the loss must be determined.
- The portion of the loss that’s unallowable in the current year must be carried forward and accounted for in the subsequent year(s).
Calculation of Allowable Rental Property Loss
After calculating the amount of net loss, the allowable portion of the loss for each property must be determined. Net rental property losses are equal to rental income less rental expenses including mortgage interest and depreciation. These two items are generally responsible for rental property losses in Southern California where I live due to the high real estate prices.
Net rental losses of real estate professionals who spend the majority of their time in real property business are fully deductible. There are two tests that must be met each year:
- More than half of the personal services in all businesses must be performed in real property and rental real estate.
- More than 750 hours must be spent in real property businesses and rentals in which the individual materially participates.
The amount of allowable rental property losses for real estate professionals who don’t meet both tests and for other taxpayers who actively participate in management decisions is subject to an income limitation. Limited partners in activities, taxpayers with less than 10 percent ownership, and trusts and corporations don’t meet the active participation standard.
For those who qualify, rental real estate losses up to $25,000 ($12,500 if married filing separate) can be deducted if modified adjusted gross income (MAGI) is less than $100,000. For every $2 that MAGI exceeds $100,000, the $25,000, or special allowance, is reduced by $1. Once MAGI exceeds $150,000, no rental property losses are deductible in the current year.
Passive Loss Carryover
Rental property losses that can’t be deducted in the current year are suspended and carried forward to the following year. Suspended losses must be kept track of on a property by property basis. They’re used in the calculation of the allowable passive loss for the subsequent year(s).
Suspended rental property losses can be used in three ways. They can be (a) offset against passive income from the property with which they’re associated, (b) offset against passive income from other passive activities, or (c) deducted in their entirety when the property is sold through a “qualifying disposition.” The third situation is the most common.
There are three requirements that must be met in order to deduct 100% of a suspended loss when a property is sold through a qualifying disposition:
- Disposition of entire interest.
- In a fully taxable event, i.e., 100% of gain or loss is realized and recognized.
- To an unrelated party.
Plan to Use Your Suspended Losses
Suspended losses from rental properties can grow significantly over a number of years. They need to be properly accounted for and carried forward each year so that they may eventually be used. It must be kept in mind that the suspended loss rules don’t reduce or eliminate the ability to deduct rental property losses. The deduction is deferred in most cases.
Subject to an evaluation of appreciation potential, you should look for opportunities to sell a rental property through a qualifying disposition if you’re unable to offset your suspended losses against passive income. Even if there will be a gain on the sale of the property, the ability to offset the gain with sizable suspended losses precludes the need to consider a 1031 exchange in most cases.
When analyzing tax savings from use of suspended losses from a qualifying disposition, the preparation of an income tax projection with and without a potential sale is critical. The income tax savings from the ability to use suspended losses may allow you to employ income recognition strategies, including a Roth IRA conversion, which you might not otherwise be inclined to do.
The passive activity loss rules that were added to the income tax code with the passage of the Tax Reform Act of 1986 was a game changer. This one change significantly increased the time and associated cost of income tax preparation for affected individuals as well as the likelihood of engaging the services of a professional for income tax planning and preparation.
If you’re considering purchasing one or more properties that will be rented, you need to do a multi-year analysis. Your analysis should include calculations of projected suspended losses as well as projected timing of when and how they will be used.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.